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Proposed section 988 regulations.

On October 8, 1992, Tax Executives Institute filed the following comments with the Internal Revenue Service on proposed regulations under section 988 of the Code, relating to the taxation of gain or loss from certain nonfunctional currency transactions. The Institute's comments were prepared under the aegis of its International Tax Committee, whose chair is Lisa Norton of the Ingersoll-Rand Company. Contributing materially to the development of the Institute's position was Joseph E. Bernot of NCR Corporation.

On March 17, 1992, the Internal Revenue Service issued proposed regulations under section 988 of the Internal Revenue Code, relating to the taxation of gain or loss from certain nonfunctional currency transactions. The regulations were published in the Federal Register on March 17, 1992 (57 Fed. Reg. 9217), and in the April 13, 1992, issue of the Internal Revenue Bulletin (1992-15 I.R.B. 47).

For simplicity's sake, the proposed regulations are referred to as the "proposed regulations." Specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.


Tax Executives Institute is the principal association of corporate tax executives in North America. Our 4,700 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 988 of the Code, relating to the taxation of gain or loss from certain nonfunctional currency transactions.

Overall, we believe the proposed regulations are well thought out and effectively implement the statutory purpose. The new mark-to-market election will provide symmetry for financial and tax accounting purposes, thereby significantly simplifying the current rules. The following comments are offered as refinements to the proposed regulations.


Prop. Reg. [section] 1.988-5(f): Mark-to-Market Method of Accounting

1. Mark-to-Market Election. Prop. Reg. [section] 1.988-5(f) permits certain taxpayers to elect to realize periodically exchange gain or loss on section 988 transactions resulting from changes in exchange rates between the date a financial accounting period begins and the date it closes, provided such treatment is consistent with the taxpayer's method of accounting for financial accounting purposes and conforms to U.S. generally accepted accounting principles (GAAP). If elected, the "mark-to-market" method must be used for all section 988 transactions.

TEI supports the inclusion of a mark-to-market election in the proposed regulations. Permitting taxpayers to conform their tax method of accounting with their GAAP method of accounting will bring some simplification to this area. Because the prerequisite to the election is consistent treatment for financial accounting reporting, however, we recommend that the consent to change for tax purposes be automatic. See Treas. Reg. [section] 1.446-1(e)(3)(ii) granting the Commissioner authority to prescribe procedures for changing accounting methods). This would be consistent with automatic consents granted in other areas. See, e.g., Rev. Proc. 84-27, 1984-1 C.B. 469 (Rule of 78s method change); Rev. Proc. 91-51, 1991-2 C.B. 779 (change of accounting method for sales of certain mortgage loans).

2. Section 481 Adjustment. The preamble to the proposed regulations announces the IRS's intention to issue a revenue procedure setting forth the terms and conditions under which a change of method of accounting will be granted. The IRS solicits comments concerning the appropriate period during which the section 481(a) adjustment should be taken into account. 1992-15 I.R.B. at 48.

TEI recommends that the section 481(a) spread should be three years, except where the section 988 transaction will expire before that time; in such cases, the adjustment should be spread over the remaining period of time. For example, if a debt instrument were executed on January 1, 1989, for five years and the taxpayer elects at the end of 1992 to mark the instrument to market, the cumulative gain or loss that arose in 1989, 1990, and 1991 should be spread over the following two years, 1992 and 1993. The amounts should retain the same character as the underlying instrument.

Alternatively, the period should be consistent with that set forth in the revenue procedure governing the mark-to-market election to be issued under Prop. Reg. [section] 1.446-4 for derivative financial instruments, with terms and conditions similar to those applicable to Category B methods of accounting in Rev. Proc. 92-20, 1992-12 I.R.B. 10. See Preamble to Prop. Reg. [section] 1.446-4, 1992-2 C.B. 951, 955 (announcing the IRS's intention to issue such a procedure when the section 446 regulations become final).

3. Relationship with Section 446 Regulations. A section 988 transaction may also be subject to the section 446 regulations (relating to notional principal contracts) which provide a similar mark-to-market election. Under Prop. Reg. [section] 1.446-4(a)(3), a dealer or trader electing the mark-to-market method may not use the lower-of-cost-or-market (LCM) method of accounting. The proposed section 988 regulations limit the use of the mark-to-market method to non-dealers in securities and are silent concerning whether such taxpayers may use the LCM method of accounting.

TEI submits that the final regulations should specifically permit dealers or traders in instruments constituting section 988 transactions to elect mark-to-market treatment and to do so without abandoning the use of the LCM method of accounting. Restricting the mark-to-market election under section 988 to non-dealers simply makes no sense, given the overlap between sections 988 and 446. Moreover, we note that the LCM method has been an acceptable method of accounting for almost 75 years. See T.D. 2609 (Dec. 19, 1917); Treas. Reg. [subsection] 1.471-2, 1.471-5 (issued in 1958; amended in 1973) (permitting the use of the LCM method to value inventories, including securities). The section 988 or 446 regulations should not be used as a forum to restrict its use.(1)

Prop. Reg. [section] 1.988-5: Section 988(d) Hedging Transactions

Prop. Reg. [section] 1.988-5(d) extends integration treatment to hedged qualified payments in a manner similar to that afforded hedged executory contracts under Treas. Reg. [section] 1.988-5(b). For this purpose, qualified payments are (1) declared but unpaid dividends denominated in a nonfunctional currency, and (2) accrued rent or royalty payments denominated in a nonfunctional currency, the amounts of which are fixed on the date the hedge is acquired.

TEI believes that proposed integration treatment for hedged qualified payments is correct. We suggest, however, that such treatment also be permitted for (1) hedges entered into by an entity other than the entity with the underlying exposure; (2) hedges entered into prior to fixing the right " obligation with respect to the underlying hedged item; and (3) hedges and related underlying transactions not recorded on the books of the same qualified business unit.

We recognize that the advance ruling procedure to be issued under Treas. Reg. [section] 1.988-5(e) permits the IRS to address many of these issues. We commend the IRS for developing a procedure that will bring much-needed certainty into this area. We suggest, however, that broader guidance be provided for taxpayers, particularly with respect to generic and common fact patterns.

Prop. Reg. [section] 1.988-2(b)(14): Replacement of Nonfunctional Currency Debt

1. Replacement Debt. Prop. Reg. [section] 1.988-2(b)(14) provides a special rule for nonfunctional currency related person debt. If the taxpayer disposes of or terminates such a debt instrument prior to maturity in a transaction in which pin or loss would be recognized, the IRS District Director or Assistant Commissioner (International) may require the taxpayer to defer such gain or loss if the debt has in effect been replaced with debt denominated in a different currency entered into with a related person, whether or not the replacement debt is in the taxpayer's functional currency.

Multinational corporations frequently reinvest cash among various subsidiaries and in various currencies for economic reasons, eg., to take advantage of favorable exchange and market interest rates and to utilize excess cash. When a taxpayer substitutes nonfunctional currency debt with debt denominated in a different currency (whether or not the taxpayer's functional currency), the taxpayer effectively terminates its exposure to fluctuation in the currency in which the first debt is denominated. The economic effect of this termination of risk was recognized by the Tax Court in American Air Filter v. Commissioner, 81 T.C. 709, 730 (1983), which held that the taxpayer's conversion of a related-party nonfunctional currency debt into a debt denominated in functional currency triggered recognition of exchange gain or loss, even though the underlying debt was not terminated.

Prop. Reg. [section] 1.988-2(b)(14) not only disregards economic reality, but attempts to overturn the Tax Court's decision in American Air Filter. TEI submits that American Air Filter is correct in holding that exchange gain or loss is recognized when the economic exchange risk is terminated. Accordingly, we recommend that the final regulations permit the District Director to defer exchange gain or loss only where replacement debt is denominated in the same currency as the debt replaced. We also recommend that such a provision be applied prospectively 30 days after publication of the final regulations in the Federal Register.

2. District Director's Discretion. In the example in subparagraph (iii) of Prop. Reg. [section] 1.988-2(b)(14), taxpayer X and a related party, Y, agree to convert a nonfunctional currency bond issued by Y into dollars, the functional currency of X. X would have an exchange loss on the transaction since the dollar value of the new debt is greater than the dollar value of the bond when first purchased. The example concludes that the District Director "may defer X's . . . exchange loss until the . . . obligation matures or is otherwise terminated in a transaction in which pin or loss is recognized." Thus, the conversion of the debt instrument and the new dollar obligation are treated as replacement debt. The example fails, however, to specify what factors the IRS will use to determine whether to defer any gain or loss. Without such guidance, there is no assurance that the rule will be applied in an evenhanded manner or provide any certainty to taxpayers. Indeed, cynical taxpayers may suspect that if the loss decreases the tax otherwise owed, such loss will be deferred. A more definitive rule should be included in the final regulations.


Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations under section 988 of the Code, relating to the taxation of gain or loss form certain nonfunctional currency transactions. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at (201) 573-3200, or Mary L. Fahey of the Institute's professional staff at (202) 638-5601. (1) At a minimum, the section 988 regulations should clarify that non-dealers may elect the mark-to-market method and continue to use the LCM method of accounting.
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Publication:Tax Executive
Date:Nov 1, 1992
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